The Current Approach to Management of Risk Will Always Fall Short

Yesterday’s Wall Street Journal carried a story: “Fed Tells Banks to Shape Up or Break Up.”. Even though the story does not specifically talk about the financial risk, it implies that banks are not doing enough to address regulators’ concerns. And addressing risk has been a significant concern since 2008. So if you combine it with their concerns that bank models almost always understate their capital requirements, it leads to a lack of trust and confidence, and may be even to mistrust.

Even if banks do all they can, there will always be a confidence gap because the current approach to managing risk can never cover the entire spectrum of risk. The problem arises because no one knows nor can define how much of the risk spectrum is not covered. And as long as there is an uncovered portion of the spectrum, banks are vulnerable. Such vulnerabilities will come to light only when the next crisis arises. Combined with the fact that risk models are too complex to follow and understand easily, there is no way to tell if the portion of the spectrum that is addressed has been done correctly or effectively. Thus banks are not only vulnerable but also no one knows how vulnerable, and whether this vulnerability is acceptable. This is the root cause of the confidence gap.

What is needed is a transparent approach that addresses the entire spectrum of risk that can be easily grasped. (See “What Stress Testing is Not”). Until this is addressed, the current approach to risk will always fall short and there will remain a confidence gap.